Don’t get bitten by positively geared property.
‘Beware the wolf in sheep’s clothing’, like most old adages, applies just as much to real estate as it does to real life. If you don’t look past the fluff and get to the facts, you could get bitten. There are plenty of ways to get bitten (or mauled) if you don’t dig deep into the details before purchasing property. And one of the biggest is the ever-popular, but often-perilous, positively geared property.
If I had a dollar for every time a person has asked me about positively geared property, I’d be able to pay cash for one right now. But I don’t think I would bother because, generally, I don’t think they’re a good bet. This might surprise some punters, so let’s peel back the sheep’s clothing and take a look at the wolf.
When a new client comes in asking me to assist them with investing in a positively geared property, it signals that they’re worried about their ability to pay for ongoing holding costs from personal cash flow.
No one should invest in anything they can’t afford. The purpose of investing is generally to acquire a portfolio of assets which will one day fund our lifestyle in retirement. The bigger the value of the assets in the future the better the lifestyle we can afford to live in retirement. This is why I believe that the primary consideration for selecting investment properties needs to be the potential for capital growth, not rental return. There are clever ways to maintain a comfortable cash flow without jeopardising capital growth potential. And those clever ways rarely include buying positively geared property.
When thinking about positively geared property, know this: properties do not increase in value at the same rate. Spruikers often say properties double in value every seven to ten years, but astute property investors know that growth on one property to the next can be miles (or millions) apart. Second, positively geared properties generally serve a specialised market and this limits their demand. If a property appeals to a limited market, competition among buyers to purchase it will be less and it won’t attract the same level of capital growth as a high-demand property. You’ll find banks aren’t as keen on specialised property either because of the risks.
Let’s look at some more common examples of positively geared specialised properties:
Their potential for higher rental returns and lower tenant turnover (because it’s very disruptive to a business to move) is an initial attractor, but if you consider that it can take six to 12 months to replace the tenant when they do decide to move (or goes bust as can happen, especially in a poor economy), the loss of rental income for such a long period makes this quite a risky proposition (and far from a positively geared gem). On top of this, commercial property valuations (the capital growth indicator) are extremely volatile, which makes resale demand for them moderate at best. Valuations are largely based on the quality of the tenant and best use of the property (whereas residential valuations are determined by comparative sales). So we start to see why banks charge higher interest rates and require greater equity for commercial property!
The National Rental Affordability Scheme is a Federal Government initiative which started in 2008 as part of a building industry stimulus package. It offers investors in NRAS properties tax incentives of up to $9,140 a year. On face value, the rental returns and tax incentives are great, but scratch the surface and ask why, if they are so great, the government isn’t holding onto them itself?
If you own a NRAS property, you must have your property managed by NRAS agents and only rent it to NRAS-eligible tenants. Property management fees are about 13 per cent (compared with 8.5 per cent for standard residential), rents must be charged to the tenant at a 20 per cent discount, and lease documents are quite involved. This dilutes the extra tax incentives. Add to this, banks are not comfortable lending money against NRAS properties. Those banks that are, require a minimum 20 per cent deposit because mortgage insurers will not accept the properties. So, you’re constrained by the size of deposit you need, as well as in your choice of bank, property manager and tenant. These constraints probably won’t appeal to lots of other buyers either when it comes time to sell. And the fact these properties are within large (mass-produced) complexes and estates puts a ceiling on the amount of possible capital growth. More negatives than positives here, wouldn’t you say?
Studio and serviced apartments
Here we’ve got low purchase price, a central (often trendy) location, and potentially higher rental returns. Sounds good, right? Not so much when you consider that these are like a basic hotel room. The rental pool is usually limited to short-term business people, holidaymakers or single people wanting a really cheap rental as a place to sleep as opposed to a home. So now we have a limited rental market with high turnover, quite probably seasonal vacancy rates, and the consequent high property management fees. Often there are also body corporate restraints or covenants dictating who can manage and who can rent the property. I’ve found appealing 6.5 per cent rental yields set against appalling 1.5–2 per cent capital growth when I’ve researched these properties. Thumbs down.
These are regular houses and apartments which investors can purchase from the Defence Housing Authority (DHA) but must lease back to DHA as accommodation for defence personnel. The property itself isn’t ‘specialised’ but the tripartite relationship between property owner, property manager (DHA) and tenant certainly is.
There’s quite a bit to like about the DHA scheme: the lease is actually between the owner and DHA so rent is ‘guaranteed’ and there are no vacancy periods. And generally DHA will lease the property for 12 years from the time it is built. DHA is also responsible for keeping a good tenant in the property and the tenant is required to hand the property back to the owner at the end of the lease in good repair. DHA properties are generally in ‘central locations’ with family amenities nearby. Plenty of ticks there.
But the negatives outweigh the positives pretty quickly when you realise you can’t use the property for anything other than defence accommodation until the 12-year period expires. And the same constraints apply to the new owners if you want to sell, which means fewer willing buyers and less capital growth. DHA charges a whopping 16.5 per cent (houses) and 13 per cent (apartments) to manage the property. Mortgage insurers don’t support DHA properties so investors must use at least 20 per cent of their capital to buy one. DHA homes are built in locations that meet DHA requirements, but not necessarily where there are other important growth drivers that property investment specialists look for in a location. Enough said?
At the end of the day, all properties should eventually become cash flow positive because rental incomes increase with (or better than) CPI while property expenses stay largely the same from year to year. I’m not saying rental return isn’t important. It is. But you I believe capital growth potential is the primary criteria when deciding on an investment property. Property investors can fail when they select a property with a rental income that meets their budget and overlook the many other factors that determine its quality as an investment decision.
That’s why a qualified property investment advisor will look at available capital and cash flow and strategically calculate the best way to invest in multiple properties safely without busting the budget. Considering what name to buy property/s in, setting up contingency funds, using innovative debt restructuring strategies, and self-managed super funds are all tools for keeping things comfortable while you wait for capital growth. But it’s not just about keeping the wolf from the door. It’s about giving the wolf a wide berth from the beginning.